Croatia’s Equity Risk Premium Development

For this week’s blog, we are bringing you an overview of the historical development of Croatia’s equity risk premium (ERP) and the comparison of current ERPs by countries.

The equity risk premium (ERP) can be explained as an excess return an investor would demand to invest in the average equity over the risk-free rate. This excess return compensates investors for taking on the relatively higher risk of equity investing. The size of the premium varies depending on the level of risk in a particular portfolio and also changes overtime as market risk fluctuates. As a rule, high risk investments are compensated with a higher premium.

Although there are many disagreements when it comes to determining a country’s ERP, it is still one of the crucial components of calculating the cost of equity and is therefore an important factor in valuing companies. It is negatively correlated with the value of a company, meaning that other things held constant, a higher ERP would lead to a higher cost of equity and therefore a lower valuation (and the other way around). 

According to Aswath Damodaran, to estimate the equity risk premium for a country, one should find the premium for a mature market and add an additional country risk premium, based upon the risk of the country in question. To estimate the mature market risk premium, one has to compute the implied equity risk premium for the S&P 500 index. This is done by calculating the implied expected return on stocks which is than deducted by the risk-free rate (T. Bond rate). As of 1 July 2019, the ERP for a mature equity market (such as the USA or Germany) amounts to 5.67%, which is close to the median ERP in the past 10 years (5.60%). In the graph below, one can notice a couple of sharp decreases in ERP such as the one during the dot com bubble and the housing market crisis, which in a way, signaled a bubble. As a comparison, current ERP is quite above the historic median of 3.89%.

Historical ERP for Developed Markets (1961 – July 2019)

Source: Aswath Damodaran, InterCapital Research

In order to calculate the equity risk premium for Croatia, one would, according to Damodaran, have to add an additional country risk premium to the premium for the mature market. Damodaran calculates the country risk based upon the local currency sovereign rating for the country from Moody’s or with the CDS spread for the country (if one exists). This would mean that based on Croatia’s credit rating since January 2019, the country risk of Croatia would amount to 4.17%, which would translate into an ERP of 10.13%.

However, since than Croatia received credit rating upgrades by both S&P (in March) and Fitch (in June), which took it to the investment grade territory. Besides that, ERP for developed markets observed a decrease of 0.29 p.p. since January 2019. Therefore, as of July 2019, Croatia’s ERP would amount to 9.06%.  We note that using credit rating is not necessarily the best way to calculate the country risk when calculating the equity risk premium, as the credit rating agencies take time to revise their ratings. Instead, another way of estimating the country risk would be by calculating the spread of the country’s EUR denominated 10 year bond and the Bund, since Bund is deemed as default free.

Croatia’s ERP Development (2009 – July 2019)

Source: Aswath Damodaran, InterCapital Research

In the graph above, you can see the historic development of Croatia’s ERP which has been fluctuating in the past 10 years. In the observed period, the Croatia’s country risk reached its peak in 2016, when it amounted to 4.7% and has been gradually decreasing since.

In the graph below, one can notice the comparison of equity risk premiums by selected countries as of July 2019. As prior mentioned, mature markets are given an ERP of 5.67%, while, on top of that, we add an additional country risk for other markets. As noticeable in the graph, it comes as a no surprise that Bosnia and Herzegovina has the highest country risk (7.33%), which translates into an ERP of 13%. North Macedonia and Serbia follow both with a country risks of 4.06%, translating into an ERP of 9.73%.

When looking at what makes one country risker than another, one should look at the sources of country risk. Such can be political and legal risk, but also the economic structure of the country. This means that the more dependent a country is on a certain industry, the more exposed it is to global macroeconomic shocks (and the other way around). Besides that countries experiencing high growth are usually more exposed to shocks than mature countries.    

ERP by Country (July 2019)

Source: Aswath Damodaran, InterCapital Research

It is important to note that when calculating the cost of equity for companies from the same country, the same ERP should not always apply just because they are incorporated in the same country. As certain companies have a significant portion of their operations outside of the country of their incorporation, the risk of operating there should be reflected in the ERP. This can be done by weighting the ERP based on revenues (or another key performance indicator) it makes in each country it operates. So, for example, when calculating the ERP for Apple one should not just use the ERP for developed markets as it does not reflect the risk of Apple operating outside of the USA.   

Dino Durrigl
Category : Blog

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